The decision regarding how to structure a business is one of the first and most important decisions a business owner will make. Each separate form of business has its unique set of advantages and disadvantages, and the business owner must evaluate the relative pros and cons of each when deciding which form to choose.
Informal Business Structure
Sole proprietorships have several distinct advantages that make them a very popular form of small business. They are quick and easy to set up, typically requiring no state registration and hence no upfront state filing fees to get the business up and running. Also, sole proprietorships report income and expenses on the owner's individual tax return, making it cheaper and easier to file income taxes for the business.
Sole proprietorships are relatively easy to manage. The business owner doesn't have to comply with various state statutes and federal regulations on corporate governance and does not have to answer to partners, other shareholders or a corporate board of directors. This enables the owner to focus more on operations and less on red tape and bureaucracy of more formal organizations.
A sole proprietorship is not without its disadvantages for both the owner and the business. Since there is no other legal entity involved, sole proprietors are personally liable for outstanding business debts. This includes rental space, utilities, leased equipment, promotional agreements, and other business-related contractual obligations. Additionally, a sole proprietor is considered self-employed by the IRS and accordingly must pay self-employment taxes on his income. This is true to a lesser extent with alternate forms of business such as a corporation or a partnership.
Difficulty Obtaining Credit
Since many small businesses fail, a sole proprietor can have difficulty getting business credit without pledging personal assets or guaranteeing business loans personally. Also, as a self-employed individual, the owner can have a hard time proving income to the satisfaction of creditors. Preparing profit and loss statements, balance sheets, and proving bank deposits can be an onerous task for a sole proprietor seeking credit.
Limited Growth Opportunities
By definition, a sole proprietor can have only one owner and cannot bring on partners without changing the company's business structure. Since the business depends on only one owner for financial support and operations management, this may limit growth opportunities and increase the overall risk of the venture.